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Jack Elder. Credit: CBS Brokerage

Financial Planning > UHNW Client Services > UHNW Client Advice

This Step Can Prevent an Income Planning Nightmare for Wealthy Clients

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What You Need to Know

  • Employers may use split-dollar to fund retirement benefits for highly paid executives.
  • One popular strategy involves policy loans.
  • If the IRS thinks disbursements are compensation, rather than loans, an executive client could face a nasty tax surprise.

One of Jack Elder’s favorite income planning ideas is checking to see whether one particular arrangement is working properly.

Elder, senior director of advanced sales at CBS Brokerage, likes to ask clients who are highly paid executives whether they have nonqualified deferred compensation arrangements. He then looks to see whether the NQDC retirement benefits are funded with split-dollar life insurance arrangements.

If a client has an NQDC plan funded with a split-dollar life insurance arrangement, Elder recommends an annual auditing process.

“Split-dollar is a powerful tool that can help the right client meet specific financial goals,” Elder said in an email interview last week. “Oftentimes, some form of split-dollar is the only way for a client to reach their objective tax efficiently.”

But, at the same time, Elder said, financial professionals have to help clients make sure the arrangements are operating properly.

“The tax consequences of a failed split-dollar plan can be severe,” Elder warned.

What It Means

One way to please clients is to help them make a lot of money.

Another way is to keep the IRS from sending them giant, unexpected tax bills.

Split-Dollar Arrangements

A split-dollar arrangement gives two or more parties a way to share costs, other responsibilities and benefits involved with owning a life insurance policy.

The arrangements are shaped by guidance from federal agencies over the years, including the preamble to a split-dollar arrangement final rule that the Internal Revenue Service released in 2003.

For retirement income planners, the arrangements that come up most often might be those used by employers to provide adequate retirement benefits for highly paid employees, through use of split-dollar arrangements to fund nonqualified deferred compensation plans.

Employers could also use split-dollar arrangements to provide ordinary life insurance benefits for key employees.

Estate planning clients could use private split-dollar arrangements to pay for trust-owned life insurance policies, to help children and other loved ones cope with estate tax and gift tax rules.

The parties can choose between an “economic benefit regime,” which might involve an employer or wealthy client paying for a life insurance policy, and another party receiving the death benefit protection, or a “loan regime,” which involves the party that owns the policy cash value borrowing the cash to pay the premiums from another party.

Split-Dollar Audits

When financial advisors perform split-dollar arrangement audits, they review the age of the arrangement, the specific accounting regimes used to set up the arrangement and how well the parties have met the requirements associated with the tax regime chosen.

The Thinking

Here are answers that Elder gave to 10 questions about split-dollar arrangement audits. The interview has been condensed and edited.

THINKADVISOR: How could a split-dollar arrangement run into trouble?

JACK ELDER: For example, consider this basic fact pattern: The employer lends $100,000 to a key executive for 10 years, but they never account for the $100,000 disbursements as loans — no note agreement or interest accounted for.

If the executive’s tax returns are audited, the IRS could reach the very logical conclusion that those $100,000 disbursements are compensation, not loans. You could have income taxes, plus underreporting penalties, plus interest.

A similar result could occur in the wealth transfer context.

Assume the family and trustee didn’t treat the $100,000 advances as loans — no documentation and no accounting. If the estate tax return is audited, the $100,000 annually look like gifts.

What could failure to audit a split-dollar arrangement mean for a client’s tax bills?

Those gifts would then reduce the family’s estate tax exemption on a dollar-for-dollar basis, potentially exposing the family to a 40% estate tax rate.

What background do people need to perform split-dollar plan audits?

Doing an audit doesn’t require specific credentials or education, per se, but providing the remedies might.

To audit split-dollar, you must be very experienced with split-dollar.

Before getting into the life insurance advanced planning industry, part of my legal practice centered on tax controversy, including defending clients from IRS audits and collection actions.

Understanding how the IRS would attack a split-dollar plan is critical. Correcting problems uncovered in a split-dollar audit may require professional legal and/or accounting advice.

Why do some clients need help from lawyers or accountants?

For example, if an audit uncovered the requirement to document the transaction or amend the legal agreements, the client would need the help of a properly licensed attorney.

As an advanced planning professional, I’m always happy to share my insights and experience with a client’s attorney, but I don’t provide tax or legal advice.

How can readers without split-dollar experience refer clients to professionals with the right expertise?

Several carriers have excellent pieces describing when to use split-dollar and how it works.

They may have very strong advanced planning support, too, but (except for a few carriers that focus on large-scale, nonqualified deferred compensation plans, such as Principal) carriers do not provide ongoing split-dollar support.

Aside from my firm, CBS Brokerage, I am not aware of any brokerage general agency or independent marketing organizations that provide formal split-dollar audits.

Most attorneys that draft these plans don’t administer them.

Unfortunately, most split-dollar plans are forgotten after they are initiated.

What are you finding when you do the audits?

Nothing has changed in many years, but I still run into insurance practitioners and lawyers who are intimidated by split-dollar or they need a long overdue update.

Are there clients with split-dollar plans who likely need audits more than others?

Yes. The clients most at risk fit into two categories:

  • Private split-dollar — i.e., premium advances made by a grantor for their irrevocable life insurance trust, or ILIT. These are often ignored and can cause unwanted, severe transfer tax consequences.
  • Executive split-dollar for small, privately owned businesses, where there are only one or two lives in the split-dollar arrangement, or arrangements.

Are there clients with split-dollar plans who may not need auditing?

Yes: If the plan was installed as part of a NQDC arrangement at a large organization with an executive benefits department.

Additionally, plans sold by large corporate-owned life insurance providers are usually fine, too, because those firms usually provide ongoing administration.

The challenges with split-dollar arise at the private or smaller levels, but there is a ton of it out there ticking like a bomb.

Are there risks involved with doing split-dollar plan audits, or with referring clients to split-dollar plan auditors?

The auditor should carefully define the scope of their services and avoid the unauthorized practice of law.

For the recommender, the bigger risk is to know that a split-dollar arrangement exists and fail to recommend an expert review.

What should financial professionals do to manage the risks?

Split-dollar should always be sold with an exit strategy in mind. In other words, the parties should know how they plan on addressing the premium advances and carrying costs.

Will the advances be paid off from the policy’s cash value or death benefits? Are there other assets available to address the advances? Regarding the carrying costs, how are they being accounted for?

Depending on the parties involved, there could be multiple correct answers, but the key is to be intentional and follow through on the plan.


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